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THE ROLE OF INFORMATION FAILURES IN THE FINANCIAL MELTDOWN. Yale M. Braunstein | School of Information UC Berkeley, Summer 2009. Introduction. Disclaimer:

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I’m not a macro-economics expert, but I do know something about the economics of risk and uncertainty, and something about markets, market failure, and appropriate regulatory response.

Overview:

A major source of the meltdown in the financial markets was the result of information failures and any “solutions” that did not address the information needs would not be viewed as anything more than holding actions that would eventually fail.

Each of these attempted fixes only made the overall situation worse by highlighting what we still did not know about the underlying valuations of the assets and derivatives at the heart of the financial side of the problem.

Original view was this was primarily a "financial" crisis. Taking that view, the first proposed remedy was a bailout of major financial institutions with some government entity using taxpayer funds to buy securities of unknown value from supposedly sophisticated money managers.

Instead we needed to both understand the scope of the problem (not just financial assets) and the underlying causes. To start, the focus should have been:

to resolve the information problems to help evaluate the suspect securities

to assist in the renegotiation of mortgages to help keep homeowners in their houses.

Banks and other financial institutions used to hold assets—some cash, real estate, securities, and the loans they made to their customers.

Some still do, but—for the most part—they now are in the business of earning fees for originating loans, buying and selling obligations of one sort or another, etc.

On the other side of the ledger, the liabilities of the financial institutions are the sums they owe others—the depositors in commercial banks and S&Ls, and frequently the deposits of other institutions as well as government agencies.

The basic principle of banking was to know the value of one’s assets and liabilities, accurately disclosing this to regulators and the public.

As the business of banking became more fee-based, the functions of loan origination, loan processing, and asset management became more separable.

Home buyers no longer dealt with a local bank that would be expected to hold and process their loan into the future. Banks provided consumer credit, via credit cards, “homeowners’ lines of credit,” and so on, but again often did not hold onto the asset.

So long as the packaging and re-packaging of these assets (loans) into financial instruments was done in a transparent fashion, the result was mostly positive.

The major loss from this change was the lack of a personal relationship with one’s “banker,” who was frequently a respected member of the local community.

There were gains in this system as loanable funds could more easily flow to growing regions and industries, and the entry of non-bank financial institutions into some parts of the market provided competition that reduced costs and eliminated pockets of discrimination.

“Near banks” and “non-bank banks” became common, and regulation was lax.

Even “simple” variable rate mortgages (ARMs) require one to understand:

Basis for the rate (the “index”)

The margin (mortgage rate – index rate)

When it can be reset

Caps

Negative amortization possibilities

In 2004, then FRB Chair Greenspan argued that ARMs were under-utilized and the reliance on traditional fixed rate loans was costing home buyers money. While the second part was technically correct, it ignored the increased risk to both borrowers and society of an increased reliance on variable-rate products. (Speech to the Credit Union National Association, February 23, 2004) .

Consider the result of a complex, no-doc mortgage on a home with an inflated appraisal. The outcome is that the underlying value of the property is unknown, the credit-worthiness of the borrower is unknown, and the precise terms of the loan and the stream of payments are also unknown. This is the exact opposite of how a reasonable credit market should operate.

“Both Mozilo and Sambol were aware as early as June 2006 that a significant percentage of borrowers who were taking out stated income loans were engaged in mortgage fraud. On June 1, 2006, Mozilo advised Sambol in an email that he had become aware that the Pay-Option ARM portfolio was largely underwritten on a reduced documentation basis and that there was evidence that borrowers were lying about their income in the application process. On June 2, 2006, Sambol received an email reporting on the results of a quality control audit at Countrywide Bank that showed that 50% of the stated income loans audited by the bank showed a variance in income from the borrowers’ IRS filings of greater than 10%. Of those, 69 % had an income variance of greater than 50%. These material facts were never disclosed to investors.”

On June 1, 2006, one day after he gave a speech publicly praising Pay-Option ARMs, Mozilo sent an email to Sambol and other executives, in which he expressed concern that the majority of the Pay-Option ARM loans were originated based upon stated income, and that there was evidence of borrowers misrepresenting their income.

… Mozilo met with Sambol the morning of September 25, 2006 to discuss the Pay-Option ARM loan portfolio. The next day Mozilo sent an e-mail to· Sambol and Sieracki expressing even greater concern about the portfolio. In that e-mail, Mozilo wrote: “[w]e have no way, with any reasonable certainty, to assess the real risk of holding these loans on our balance sheet. ... The bottom line is that we are flying blind on how these loans will perform in a stressed environment of higher unemployment, reduced values and slowing home sales.”

“Starting in 2001, when a new wave of government regulators took over and adopted a less intrusive attitude, Placid and other huge home mortgage companies became aggressive in their pursuit of new loans. They advertised heavily, especially on the Internet, and convinced millions of lower- and middle-class Americans they could indeed afford to buy homes that they actually could not afford. The bait was the old adjustable-rate mortgages, and in the hands of crooks like Placid it was adjusted in ways never before imagined. Placid sucked them in, went light on the paperwork, collected nice fees up front, then sold the crap in the secondary markets.” (pp. 152-153)

A financial intermediary (bank, brokerage house, etc.) would combine various coupons from a number of bonds so that an investor could find the maturity and rate of return desired independent of what the borrower had originally offered.

It was a straight-forward operation to determine the value with a computer.

Also, there was no physical “coupon” as such, just the computer entry.

The intermediary charged a small fee to record and manage the transactions.

“Simply put derivatives are the weapon of choice for gaming the system….Derivatives provide a means for obtaining a leveraged position without explicit financing or capital outlay and for taking risk off-balance sheet, where it is not as readily observed and monitored….Viewed in an uncharitable light derivatives and swaps can be thought of as vehicles for gambling; they are, after all, side bets on the market.”

--Richard Bookstaber, author of A Demon of Our Own Design, in congressional testimony.

“Even when derivatives do allow financial risks to be transferred, that is not always a good thing. John Kay, a leading Scottish economist, noted recently that he used to teach — along with most other economics professors — that derivatives allowed risks to be transferred to those better able to bear them. But, he added, experience had shown that to be wrong. Now, he said, he teaches that derivatives allow risk to be shifted from those who understand it a little to those who do not understand it at all.”

Collateralized mortgage obligations (CMOs) are bonds based on home mortgages with a twist that the bonds are categorized into different tranches to redistribute the risk of mortgage prepayment and mortgage default.

“Tranche” is French for “slice”, and is used in finance to refer to one portion of a group of related securities.

Grampa and Mr. Burns enter into a tontine during World War II, involving a treasure of antique paintings stolen from a German castle. When the two of them become the only surviving members, they compete for the rights to the prize. Eventually they both lose once the US State Department interferes and takes the paintings back to the German baron who is the rightful owner. (From Wikipedia entry for “tontine”.)

Season 7, episode 22: "Raging Abe Simpson and His Grumbling Grandson in ‘The Curse of the Flying Hellfish’”. Originally aired April 28, 1996.

Formally, a bucket shop is a firm that “books" (i.e., takes the opposite side of) retail customer orders without actually having them executed on an exchange.

From the Financial Times:

The bank panic of 1907 is remembered for J.P. Morgan forcing all the bankers to stay in a room until they agreed to contribute to fixing the crisis. What has been forgotten is one major cause of the crisis – unregulated speculation on the prices of securities by people who did not own them. These betting parlours, or fake exchanges, were called bucket shops because the bets were literally placed in buckets. The states responded in 1908 by passing anti-bucket shop and gambling laws, outlawing the activity that helped to ruin that economy. (March 30, 2009)

These laws were pre-empted by the Commodity Futures Modernization Act of 2000.

A contract between two parties, in which one party makes periodic payments, while the other agrees to pay a sum of money if a certain event occurs. A CDS takes place in the world of financial markets, and the "event" that triggers the payoff is when a credit instrument, such as a bond or loan, goes into default.

CDS pricing: The spread is an annual amount that the buyer must pay to the provider of the CDS over the length of the contract, expressed as a percentage of the notional amount. This is very much like the premium paid in insurance. In general, a company with a higher CDS spread is considered more likely to default by the market, and a higher fee would be charged to protect against this happening.

Other valuation issues: the length of the contract, the amount of protection, “health” of the issuer (as well as of the covered entity).

“Bank of America Corp. is operating under a secret regulatory sanction that requires it to overhaul its board and address perceived problems with risk and liquidity management, according to people familiar with the situation…. Citigroup Inc. has been operating since last year under a similar order with the Office of the Comptroller of the Currency, according to people familiar with the matter. The company recently has been negotiating with the Federal Deposit Insurance Corp. about entering into a similar agreement with that agency, these people say…. Spokesmen for Citigroup and the FDIC declined to comment.

“Some 9% of eligible borrowers have received trial modifications under the Obama administration's ambitious effort to help struggling homeowners, according to data released by the Treasury Department on [Aug. 4, 2009].”Maya Jackson Randall & Jessica Holzer, WSJ

Ignored differing incentives of originators, servicers, and holders of loans

Second mortgages & HLOC are profitable for lenders. But they are subordinate to first mortgages. If a lender and borrower want to re-negotiate a first, they may need the holder of the second (or HLOC) to also take a write-down in order for the borrower to afford the revised first.

Recognizing this, the “book” value of the second should be reduced, forcing the bank to incur additional losses.

“If you live in a house and you don’t buy reputable insurance and a fire burns it down, it’s your fault.”

Unwind the contracts (“inversion”)

Insurance premiums would be refunded to buyers of credit protection from the entity that wrote the initial contract. And the seller would no longer be under any obligation to pay if a default occurred. The premium repayments would be made over the same period and at the same rate that they were paid out. If a contract was struck three years ago and charged quarterly premiums, the premiums would then be refunded quarterly over the next three years.

Counter argument from an insider: “Unwinding CDS would harm the integrity of financial market. Kind of like if I place a bet with a bookie that doesn't pay, the bookie can't pick and choose after the fact which games he wants to payout on and which he wants to cancel. Not without risking have customers fleeing.”

CW (early July 2009): Actually, these last two seem to have worked reasonably well, at least when compared to the AIG bailout. But were they worth the cost?

CW (late July 2009): “The dozens of insurance companies that make up AIG show signs of considerable weakness even after their corporate parent got the biggest bailout in history, a review of state regulatory filings shows.” NY Times, July 30, 2009

(I guess) the theory is that if one only has to put up (say) 5-20% of the purchase price, the “correct” valuation isn’t too much of an issue.

But this leads to its own set of strange incentives:

Some banks are prodding the government to let them use public money to help buy troubled assets from the banks themselves. Banking trade groups are lobbying the Federal Deposit Insurance Corp. for permission to bid on the same assets that the banks would put up for sale as part of the government's Public Private Investment Program.

“PPIP was hatched by the Obama administration as a way for banks to sell hard-to-value loans and securities to private investors, who would get financial aid as an enticement to help them unclog bank balance sheets. The program, expected to start this summer, will get as much as $100 billion in taxpayer-funded capital. That could increase to more than $500 billion in purchasing power with participation from private investors and FDIC financing.” (WSJ, May 27, 2009)

Some critics see the proposal as an example of banks trying to profit through financial engineering at taxpayer expense, because the government would subsidize the asset purchases.

"To allow the government to finance an off-balance-sheet maneuver that claims to shift risk off the parent firm's books but really doesn't offload it is highly problematic," said Arthur Levitt, a former Securities and Exchange Commission chairman who is an adviser to private-equity firm Carlyle Group LLC.

"The notion of banks doing this is incongruent with the original purpose of the PPIP and wrought with major conflicts," said Thomas Priore, president of ICP Capital….

One risk is that certain hard-to-value assets might not be fairly priced if banks are essentially negotiating with themselves. Inflated prices could result in the government overpaying. Recipients of taxpayer-funded capital infusions under the Troubled Asset Relief Program also could use those funds to buy their own loans. (WSJ, May 27, 2009)

“To deal with the problem, issuers of asset-backed securities should provide extensive detail in a uniform format about the composition of the original pools and their subsequent structure and performance, whether they were sold as SEC-registered offerings or private placements. By creating a centralized database with this information, the pricing process for the toxic assets becomes possible. Making such a database a reality will restart private securitization markets and will do more for the recovery of the economy than yet another redesign of administrative agency structures.”(Ken Scott & John Taylor, WSJ, July 21, 2009)

“Insufficient data are collected on individual loans, and often the data are of questionable accuracy or timeliness, so the analysis of mortgages and other types of loans which have been sliced and diced through multiple levels of securitization will be subject to substantial error. Accordingly, the valuation of such ABS will be highly suspect, even if the data reside in a centralized database…Rather than using securitization to shift individual loans toward their funding source, public policy should seek to encourage lenders to retain ownership of the loans they make.”(Bert Ely, WSJ, July 27, 2009)

“Treasury Secretary Timothy Geithner blasted top U.S. financial regulators in an expletive-laced critique last Friday as frustration grows over the Obama administration's faltering plan to overhaul U.S. financial regulation, according to people familiar with the meeting.The proposed regulatory revamp is one of President Barack Obama's top domestic priorities. But since it was unveiled in June, the plan has been criticized by the financial-services industry, as well as by financial regulators wary of encroachment on their turf.Mr. Geithner, without singling out officials, raised concerns about regulators who questioned the wisdom of giving the Federal Reserve more power to oversee the financial system. Ms. Schapiro [SEC] and Ms. Bair [FDIC], among others, have argued that more authority should be shared among a council of regulators.” WSJ, Aug. 4, 2009